The Fair Tax: Is It Too Good To Be True?

by Joe Plemon on April 7, 2010

Close your eyes and dream for a moment. Ready? OK. The IRS was just dissolved. No more federal income taxes. No Social Security/Medicare taxes either. Or capital gains taxes or gift taxes or estate taxes or self-employment taxes or corporate taxes.

Could this ever become a dream come true? If the advocates for the Fair Tax have their way, yes. The concept has been around for several years, but has become more refined and has recently been gaining bi-partisan grassroots support. I wonder…”Is Fair Tax an oxymoron or could there really be such an animal?”

What is the Fair Tax?

The definition, according to FairTax.org , is “The FairTax Plan is a comprehensive proposal that replaces all federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax, a prebate to ensure no American pays federal taxes on spending up to the poverty level, dollar-for-dollar federal revenue replacement, and, through companion legislation, the repeal of the 16th Amendment.”

I have to say that a national sales tax which replaces all current federal taxes and provides the same federal revenue piques my interest. I am thinking, “It seems way too simple…what are the catches?” Explore this with me. I will share some advantages of the Fair Tax plan (found at the FairTax.org site) and then dig into any “catches”.

What are some advantages of the Fair Tax?

Americans take home 100% of their paychecks.

The exception would be state income taxes, but there will be no federal payroll deductions of any kind.

Retail prices will no longer hide corporate taxes or their compliance costs.

According to Dr. Dale Jorgenson of Harvard University, hidden income taxes are currently passed on to the consumer in the form of higher prices for everything we buy, boosting those retail prices by 20%. Because the Fair Tax puts an end to corporate taxes, retailers can be totally transparent in their pricing, bringing about clean competition and lower prices.

No taxes on used goods.

With the Fair Tax, you are only taxed once on goods and services. Used goods (used car, used home, used appliances, etc.) will not be taxed.

The Fair Tax is transparent and simple.

It will be charged just as sales taxes are charged today: whatever you buy and however much you spend, you will see exactly how much of your purchase goes to support the federal government. In contrast to our current system, one might not even need to be concerned about how long to keep their tax information.

The Fair Tax brings jobs home.

Because the FairTax removes the cost of corporate taxes and compliance costs from the cost of U. S. exports, these exports will be on a level playing field with foreign competitors. Lower prices means more demand for U. S. exports which translates into more American jobs.

The Fair Tax will make honest taxpayers out of tax evaders.

Although the number could be higher, the IRS admits to 16% noncompliance with the code. However, this does not factor in the criminal, drug and porn economy which is estimated conservatively at one trillion dollars of untaxed activity…all of which will be taxed when paying retail for anything. Furthermore, illegal immigrants who duck income taxes will not be able to avoid the FairTax.

What are the “catches” to the Fair Tax?

Repealing the 16th Amendment.

As already mentioned, the 16th Amendment, which authorizes Congress to levy an income tax, would need to be repealed. This could be difficult.

It might be cost prohibitive, especially to lower income families.

A sales tax rate of 23 percent would need to be imposed in order to generate $2.586 trillion dollars ($358 billion more than it replaces). Is 23 percent prohibitive? Not according to FairTax.org. Because the Fair Tax is not applied to necessities (via the distribution of “prebates”), the actual percent paid is less than 23 percent for all income levels. The following chart shows the effective percent rate of taxes paid by a family of four with two children, and this is if they spend all of their income! Notice that this family would need to spend over $29,140 before paying one dollar of taxes.

Wouldn’t it penalize retailers who have to raise prices to cover the cost of the Fair Tax?

Not really. All retailers would be need to be making allowances for the Fair Tax, so the playing field would be level. And there would be some savings to offset the Fair Tax, such as no employer match for Social Security and no corporate taxes. Also, retailers will be paid for administering the tax.

Couldn’t Congress simply raise the Fair Tax rate once it goes into effect?

Certainly. But shame on tax payers who would allow them to do so. Because the Fair Tax is highly visible and at a single tax rate, Congress will not be able to raise it without the accompanying publicity and disclosure.

Summary

The Fair Tax, in my opinion, is a great way to simplify the federal tax system in an equitable and transparent way. Although I admittedly could have dug deeper into this concept, there seem to be no obvious downsides to it (my Google search for disadvantages of the Fair Tax found very few objections). I like the idea of being penalized for spending money instead of earning money. The more I think about it, the more sense it makes. In fact (excuse the cynicism), it just makes too much sense for me to believe there is a chance that Congress will pursue it.

My prediction is that our legislators, in their ever increasing search for funding, will keep the current behemoth IRS system in place and implement a VAT (Value Added Tax) in addition to it. I hope I am wrong.

Readers: Help me out here. What have I missed? Are there downsides to the Fair Tax that I overlooked? Do you think it has a chance of ever becoming reality?

I too believe the Fair Tax could save our economy. But the only way things happen is with money. Unfortunately NRST has been offered for over 10 years and nothing has happened. I believe the Fair Tax. Org has elevated the fair tax to its highest level so far. But I am not sure they can ever raise the amount of money necessary to overcome their adversaries. Those with agendas and power in Washington have access to the power and the money to put the Fair Tax down while they spin right into wrong.
Believing it is money that is the only way to make things happen I have constructed an approach that will compensate those that get involved and help us make the fair tax a reality by November 2010. Acorn got incredible results and didn’t need to become illegal. When I saw what they accomplished with relatively a small amount of money I was amazed. I discovered that an endless supply of money is available that could reward those that do the most the largest rewards. If anyone is interested in discussing it, please email me. I believe that if you can pay a person a healthy income to help us make it happen we can get a 1000 times the results of Acorn.
Joe your questions were right on.

Daniel,
Yes, it is a long shot and yes, the fair tax may be overreacting. I am not sure that I agree that we’ve done well for the past 80 years…I suppose that depends on how you define “well”. Right now, from the vantage point of a guy who hates debt, we seem to be digging a bigger and bigger hole for ourselves. We could fix our own problems without the FairTax if Congress could learn to live on a budget, and the FairTax, in and of itself, wouldn’t produce that result. But I still think it would be a step in the right direction because of its simplicity and transparency.

About Social Security…sorry. It doesn’t go away with the FairTax proposal; it is just collected differently. But if I was in your shoes (I am Social Security age), I would also want to handle my own investments instead of filtering them through the government’s hands in the form of Social Security.

Thanks for the review. There is another reason why this would never pass (unless we have a lot of support in the house, senate, and have a fair president). The reason is power to the people. Congress likes the IRS system because they can control us. They dictate how much credit we get and don’t get and in the end how much taxes we have to pay. With the fairtax the people basically have more control and can vote with their purchases – if that makes sense.

Also, someone commented the fairtax might be over-reaching. Quite the opposite. Yes, the fair tax idea might seem too big of a shift, but it is exactly what we need. Here is why: Jobs Jobs Jobs. As Joe mentioned, the fairtax would create a lot of jobs. According to the fair tax book (2nd one) there would be so many jobs created we would have to import people over to fill the jobs, because there would not be enough Americans to fill them.

There is one more “big” benefit. Supposedly 12 trillion dollars of big corp sits in offshore banks. In the fairtax world, there are no capital gain taxes or taxes on investments. So, that 12 trillion would come floating back over to the US. Think about that… What bank would not welcome a flood of cash? And in the end, business would be able to borrow money and lending rates would fall – stimulating the economy even more.

How can we support the fairtax and try to make it law? Start local. Call your state reps and senators and start asking them to support the fair tax bills (HR 25 and Senate version).

We don’t see much chance of the Fair Tax proposal becoming a reality. Is the current tax system really about revenue or control? The government gets far more mileage out of the intimidation factor than they do out of the revenue. After all, the current tax revenue generated falls far short of the current out-go and they (the US Gov’t) just prints the shortfall. We agree, the more likely scenario to evolve will be the addition of the VAT to the existing tax scheme instead of it serving as its replacement.

That said, the real threat we face, in our view, is the hidden tax of inflation which will represent a far more burdensome tax than all of the others combined. It will be felt with every purchase of goods and services we make. The only way to reduce, avoid, or evade the hidden tax of inflation is to the degree we are successful in reducing our consumption across the full spectrum of our budgets. Sadly, this reduction in consumption will negatively impact jobs, existing tax revenue streams, and home values. We are in the very early stages of a continuing and downward economic spiral.

The upside to our gloom and doom projection is that the downward economic spiral has a terminal end. Once the current financial system completely implodes, we can begin building something better from scratch and on a much better financial foundation.

Steven and Debra,
Yes, inflation is going to affect us all…those on fixed incomes will suffer the most, but we will all need to do as you state: rein in our lifestyles and live within our means.

I am glad you pointed out that there is an upside. Things will undoubtedly get worse before they get better, but even if we have to restart from scratch, the foundation will be there. But no politician wants that to happen on their watch, so they keep using expensive band aids to cover the real problems.

Elvis,
You make so much sense! More jobs, more available cash in American banks…which makes the Congressional control issue you described all the more exasperating.

I would like to hear one good objective objection to the Fairtax. So far, I haven’t heard any. But, like many have said, it is probably a pipe dream because it is so simple and transparent … not good for politicians who want to benefit special interests groups.

Sorry, but this is too good to be true. Why are taxes so complicated? Because there are hundreds of different groups lobbying for exclusions, bonuses, lower taxes, deductibles, higher taxes…Implement the fair tax and in 3-4 years the beast is back!

Canada,
You are probably right about the beast coming back within 3-4 years after the Fair tax would be implemented. The problem of opportunistic politicians would not be changed by new legislation. We all know that you can’t legislate morality and immoral legislators would be the last to do so. But even if we could tie their hands for 3-4 years we would be better off.

Ah, the Fair Tax. I used to think this was pretty close to the best possible tax (with the possible exception of that Utopian fantasy of no taxes at all); however, I’ve soured on it a bit as of late. So, if you’ll allow me to play Devil’s Advocate for moment, here are some of the faults that I see:

My first fear about the fair tax has to do with our foreign trading partners. It’ll raise the price of foreign produced goods in US markets, possibly triggering a backlash where foreign countries will initiate their own tariffs on our exports (decreasing foreign sales and the competitiveness in foreign markets that the Fair Tax was supposed to restore). The only options to prevent such a tariff might be to allow foreign made goods to be sold Fair Tax free, which will put American made goods at a disadvantage and possibly require the level of taxation to be increased on said goods, further harming the market for US made goods in the US.

Even if this isn’t the case, the tax could make buying goods in foreign countries look more attractive; much as income taxes lead earnings to go off-shore, the same thing could happen with spending. Look at the number of people who sneak into Canada to buy cheaper medications; now imagine that everything being sold in Canada is cheaper, because they aren’t imposing a 23% surtax on everything. (Now, the Fair Tax people did try to address this complaint on their website, noting that you need to declare anything you’re bringing into the country and pay taxes on items brought back, if you’re a United States citizen. But, given the number of people who get across the borders for immigration purposes, I’m not holding my breath that that plan will work, at least without a massive increase in border security.)

There’s another issue for which I’ve never gotten a reasonable answer; how do you distinguish taxable spending from tax free spending? The exemption for used goods (and business purchases, another feature of the Fair Tax) sounds good, but how is it administered? If you’re a small business owner doing shopping at the local mall for needed office supplies, how do you prove it’s untaxable? Do we end up with having to fill out a (short) tax form every time we try to buy something in order to get the tax taken off, or worse, have to wait until we submit an annual form to get the excess tax money paid back? Either method seems to greatly decrease the ease with which the Fair Tax can be administered and the advantages to business people (and anyone who’d like to buy a used car).

As for making honest tax payers out of tax evaders, that’s debatable. Unless the Fair Tax people are also advocating legalizing drugs and prostitution (a decent idea, but outside the purview of the Fair Tax), these activities will still occur off the radar and be untaxed. Since much of the money works its way back to foreign countries and the drug barons or other crime lords therein, the economic benefit is likely to be much less than predicted.

On the subject of illegal activities, there’s also the possibility that the Fair Tax could lead to more illicit actions (or at least, not decrease the number of tax cheats as much as claimed). Much as income taxes (and minimum wage laws) cause people to hire workers ‘under the table’, so too might spending taxes lead to more spending being done in a hidden, untaxable fashion (see the above paragraph about spending in foreign countries and smuggling the proceeds back to the US). It becomes a situation with two bad choices; either strictly enforce the tax and spend excess money and manpower on tax collection (exactly what eliminating the IRS was supposed to avoid), or allowing lax enforcement, enabling people to evade the tax.

Finally, one last point (more a quibble, really, especially compared to some of the elephants in the room that have already been mentioned): the Fair Tax, not being directly connected to income, isn’t necessarily progressive in nature. The chart of effective tax rates you presented makes two big assumptions: one, that all families mentioned spend all of their income, and two, that none of them spend any of their prebate. If lower income families need to spend their prebate money, they’ll end up paying Fair Tax on that spending, as well, boosting up their effective tax rates. Likewise, higher income families or persons can afford to spend less than their full income and still live very comfortably (in fact, since their spending is now taxed, they will have even more incentive to do so), meaning they’re likely to pay less in taxes, as a portion of their income, then the less well off. All of this only really matters, though, if we’re determined to ensure that our tax system is progressive (which it isn’t REALLY right now, for that matter); if we don’t mind that at least some rich people will pay a lower percentage of income as taxes compared to some of the middle class or poor, then there’s really no problem.

Now, all of this does not mean that I don’t think that the Fair Tax wouldn’t be an improvement on our current tax system; it would, if it works as planned, definitely be a large improvement. (Of course, just about any system, including my preferred version of a much simplified, gradually progressive tax, would almost by definition be better than the current jumble of tax laws we call a tax system.) I just wanted to point out some of the flaws that haven’t really been addressed. This is far from a complete list of potential problems; I’m not an economist, just a money blogger (albeit, hopefully a well informed one).

If (when?) the Fair Tax actually becomes a major political force, I’m sure that plenty of economists will start to look at it closer and see what other flaws it might have, the supporters will have to address the flaws in one way or another, and so the discussion will advance. For now, just consider this a caveat that every tax system has ways in which it is less than ideal, and issues that should be addressed.

Roger,
Wow! I asked readers to fill in blanks of what I might be missing. Thank you for doing so in a very well thought out and well presented manner. These are the types of arguments I was searching for when I put this post together, but there is little (that I could find) readily available info against the concept of the fair tax. I hope every reader takes time to read and think through your comments. In fact, I think you ought to put them together as a post.

About the specific issues you raised…I am not qualified nor capable of countering them. That is why I posed the question, “Is it too good to be true?” in the title of my post. I am sure the proponents of the Fair Tax could give some logical rebuttals, but, like you said, if the Fair Tax ever becomes a major political force, economists from both sides will need to deal with these and other perceived flaws.

Still, I would like to see the debate happen, just for the exercise of flushing out the problems we now have with our all-pervasive system. Have you noticed, since I wrote this post, that the VAT is gathering momentum? This is one time when I hope to be a false prophet!